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The role of bonds and hybrids in franking loss

Most of the discussion on Labor’s proposed changes to franking credits has focused on how retirees and investors in SMSF pension phase might experience a significant fall in their (after-tax return) income.

Little has been written about the impact on bonds and hybrids and the solution they may provide. It is also a timely reminder to assess regularly the asset allocation and balance of investment portfolios. The current environment provides a unique opportunity to potentially decrease risk and increase overall return with a reallocation between cash, bonds and equities.

Currently, individuals and superannuation funds are entitled to a refund of franking credits if the franking credits plus any PAYG tax paid by the individual or fund exceeds their tax liability. Under Labor’s proposal, with some exceptions such as the ‘pensioner guarantee’, refunds that exceed tax liabilities will no longer be available for most taxpayers.

Potential loss of income

The practical implication is that retirees and in particular SMSFs in pension phase are most at risk of losing significant franking credit cash refunds. This can reduce after-tax dividend income by up to 30%.

For example, an SMSF in pension phase (hence 0% tax rate) with a share portfolio of $1.5 million earning a dividend yield of 6.0% plus franking would currently be entitled to a refund of $38,571.43. Under the Labor proposal, this entire refund could be lost for some investors.

$1.5 million x 6.0%/(1-30% tax rate)

= $1.5 million x 8.57% fully franked dividend

= $128,571.42 of which $90,000 is received in cash and $38,571.43 in franking credits.

How hybrids are different

The same SMSF with $1.5 million in franked hybrids paying 6.0% (inclusive of franking), as opposed to dividend paying shares, would have lower overall income and franking refund component.

This is because the market quotes share dividends as a yield before franking whereas hybrids are quoted inclusive of franking. A 6% dividend on say a bank share is actually 8.57% (or 42.9% higher) when franking is added. A 6% fully franked hybrid pays $63,000 in cash income and $27,000 in franking credits. The latter is at risk of being lost to some investors.

There are also a number of strategies specific to bonds and hybrids which have received little commentary. In particular, bonds and hybrids can provide effective solutions for those who need to maintain high income levels. Options include investing in:

A high-income bond portfolio. Bonds do not have any franking credits and a relatively conservative bond portfolio can be tailored with returns of 6-7% p.a. For investors comfortable with sub-investment grade bonds, the ability to construct a high-yielding portfolio of 7%-plus is possible as there are a number of bonds with returns in the high single digits including 6-12-month senior secured property bonds with low Loan to Valuation Ratios around 50%. A number of foreign currency bonds also come with high running yields such as the Citigroup USD 3mth Libor+6.37% and the NCIG 12.5% USD bond (but these also carry currency risk).

Indexed annuity bonds which pay down principal and interest over their life. These are typically issued by very high-quality A, AA and AAA rated government or public private partnership (PPP) entities and are also indexed to inflation, providing excellent protection. The downside is that at the end of the term the capital value has been completely exhausted but they are a good vehicle for those looking to enhance the cash return received each quarter

Hybrids that pay no or minimal franking credits. Two of our favoured AUD investments across the bond and hybrid market are the ASX listed National Income Securities (ASX:NABHA) and Macquarie Income Securities (ASX:MBLHB). These legacy Tier 1 hybrids were issued in 1999 and neither has any franking attached to their distributions. We expect both of these securities to be redeemed for $100 before 2022. While the running yields are 3.6% and 3.8% respectively, with the current prices in the high $80s, yields to call of over 10% are expected, adding to the consistent 10-15% annual return each has provided since early 2016. Repeating, none of the return includes a franking component. A number of ‘new style’ Basel III-compliant hybrids are also available with minimal or partial franking credits including those issued by AMP and Macquarie Bank.

Over the years we have often written that we do not subscribe to the view that ‘all hybrids are bad’. Rather we suggest investors consider the specific risk and return parameters of each security (including the impact of franking credits). At present, we still see value in legacy hybrids with no franking credits but generally believe new style hybrids are a touch expensive given the risk of a possible sell-off following a Labor election win. However, should credit margins on new style hybrids approach +5% again, we would most likely see value outweighing those risks.

An opportunity to review portfolios

The Labor franking policy provides an opportunity for investors to consider not only their tax position but also their overall investment portfolio balance. As a general rule, most Australians (and in particular SMSFs) are over-exposed to property, equities and cash. On the flip side, we have one of the lowest exposures to bonds of all OECD countries. Direct investment in bonds (as opposed to via a managed fund) is less than 1% across the SMSF sector.

With cash rates at 1.5% and market predictions of further RBA cuts, term deposit rates are likely to have a ‘1’ handle for some time. After factoring in inflation, many cash positions generate a negative real return. Large cash positions represent a drag on portfolios that can be replaced with a variety of bonds yielding 3.5-6.0%. If Labor’s franking policy is enacted, investors could reduce risk and volatility and maintain or even increase (after-tax return) income by re-assessing their allocation to bonds and select hybrids.

Justin McCarthy is Head of Research at BGC Fixed Income Solutions Australia, a sponsor of Cuffelinks. This article is general information and does not consider the circumstances of any individual. Investors should consider their risk appetite and product knowledge and seek financial advice before taking action.

9 Responses to The role of bonds and hybrids in franking loss

It is my understanding that Macquarie Income Securities (MBLHB) do not qualify as Tier 1 capital. Is the expectation of redemption prior to 2022 based on this fact. On the flip side these securities are perpetual and paying a low rate of interest compared to other hybrids. Wouldn’t it be attractive to the bank to just use them as a cheap funding mechanism compared to other forms of finance and not redeem the securities, regardless of the Tier 1 capital issue? Has the bank made any public comments indicating that redemption is likely or a possibility?

The MBLHBs currently count partially towards Macquarie’s capital ratios but from 1 January 2022 they will no longer count towards capital ratios at all. This is the main reason we expect them to be called/redeemed before 2022. It is possible that Macquarie will decide to keep the MBLHBs outstanding but when assessing the total cost to Macquarie you need to consider that they cannot use franking credits to pay for any of the coupon (as is typically the case for new style hybrids) and depending on the ATO classification as debt or equity, Macquarie may not be able to claim a tax deduction for the interest paid. On balance we have assigned a 90% probability of call/redemption before 2022. Macquarie has not made any comment on their call intentions which is very typical of financial companies and callable securities.

A relatively conservative bond portfolio with 6-7% per annum returns? I would like to see the constituents. Is this income or total return? And the expected growth component is based on an assumption on interest rates of x?

There are many ways to structure a bond portfolio to suit individual needs. A very high quality/all investment grade portfolio with income (or ‘running yield’) of 6-7% could be constructed by focusing on high coupon fixed rate bonds, however the overall yield to maturity would be closer to 4-5% as many of those high income bonds are trading over par. When talking about a ‘relatively conservative bond portfolio with 6-7% per annum return’ we would be looking at a mix of fixed and floating rate bonds, using the current market assumptions for future interest rates. The expected yield to maturity or total return is 6-7% with approximately 5% from income and the balance from anticipated capital gains from a small number of selected securities such as the investment grade ASX listed NABHAs. Investment grade/sub-investment grade mix would be approximately 70/30. Constituents would include names such as NAB, Macquarie Bank, Barclays Bank, Members Equity, SBS Bank, NextDC, Centuria, QBE, Citigroup, AT&T, Incitec Pivot, ASCF, AFC and MoneyMe.

Hi RJM, I think we are talking about different things. You are saying you will lose your franking credit. I am saying that even after using all my franking credit, I still pay tax. So I will be unaffected. I pay tax. I would love my ‘tax return to be lost’, but they will still come looking.

Difficult to know whether other hybrids will fall in price if Labor is elected. The market has had enough warning, and I saw some numbers recently that the majority of SMSF are still in accumulation, and therefore can use the full franking.

RJM, they are no lost. Tax is paid on contributions as well as income on all assets, so the franking credits earned on Aussie shares can cover all this. In fact, I have a large, diversified SMSF and I utilise all my franking credits and still pay tax.